Private Equity Laws Leading Lawyers on Structuring Funds, Identifying and Negotiating Key Deal Terms, and Complying with Industry Regulations

Transcription

1 I N S I D E T H E M I N D S Private Equity Laws Leading Lawyers on Structuring Funds, Identifying and Negotiating Key Deal Terms, and Complying with Industry Regulations

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3 Mastering a Dynamic and Innovative Capital Market Stephen Culhane Partner King & Spalding LLP

4 Private Equity Fund Formation Inside the Minds My work as an attorney specializing in private equity law generally involves advising clients with respect to the formation and management of private equity funds. Private equity funds are unregistered funds, usually organized as limited partnerships that are sold on a private placement basis to institutional and high net worth investors. Investors in private equity funds, or limited partners, typically commit to contributing a specified amount of money to the fund when the general partner of the fund calls the money from the investor. The fund calls money in order to make investments and to pay fees and expenses, and then returns money to investors when the fund s investments are sold. Most funds have five or six years to invest their capital and must return their capital and cease operations within ten to twelve years from the time they commenced operation. My private equity fund formation practice includes structuring private equity funds to most effectively address the concerns and issues that affect the fund sponsor or manager and the anticipated investors in the fund and providing guidance and advice regarding the legal, economic, and other business terms governing the relationship between the fund, its managers, and investors. While private equity funds are generally subject to less onerous regulation than funds that are registered for sale to the public, private equity funds nonetheless are subject to a web of laws that affect how the funds are structured, sold, and managed. Forming individual funds often involves a process of seeking to find the most favorable structure in order to maximize the legal and economic benefits to the fund sponsor and the investors in the fund and ensuring that the fund and its stakeholders comply with the various laws affecting the fund. This process often involves a balancing act in which the interests of certain constituencies (e.g., taxable or tax-exempt investors; U.S. or non-u.s. investors; private or public pension plan investors; and, above all, the general partner and the limited partners) are subject to conflicting business, tax, or other regulatory considerations. As a practical matter, the principal resources that enable us to add value for our clients are our familiarity with the private equity funds market and our experience in establishing and advising managers of private equity funds.

5 Mastering a Dynamic and Innovative Capital Market While many law firms will have standard fund documents as a general rule, private equity fund lawyers create value for their clients through the application of detailed knowledge of what people are doing in the marketplace, the spectrum of approaches to similar issues, the principal areas where mistakes can be made, and the application of this experience in a way that best advances the interests of their clients. Over the course of my career, I have advised sponsors of more than 100 private investment funds and investors in hundreds of investment funds. This experience has allowed me to accumulate a sense of what works and what doesn t, to learn from the things that can go wrong, and to reduce the friction points that affect fundraising and the subsequent management of a fund. A detailed knowledge of the things that can go wrong, gleaned from working with numerous funds, fund investors, and other private equity fund professionals, can be tremendously valuable and enables us to assist clients in anticipating challenges and avoiding mistakes. Mistakes In many ways, one of the most expensive areas to make a mistake in involves the fundamental economics of the fund. While there is a general consensus in the private equity industry regarding fees and how they are paid, the finer details of a fund s economics can involve significant amounts of money. Typically, private equity funds will charge a management fee of between 1.5 and 2.5 percent of committed capital during the investment period and step down after the investment period ends; the general partner or an affiliate also will receive 20 percent of the fund s profits. A principal area where mis-pricing may occur involves the fund s distribution waterfall. The distribution waterfall is the term for the way in which capital is returned to a fund s investors as underlying investments are sold. As an example, some funds will give their limited partners a full priority return in this model, an investor gets all of its money back and often a preferred return (the equivalent of interest on contributed capital) before the general partner may participate in the profits. Other funds will give their investors a priority return of realized invested capital in this situation, also known as a deal-by-deal waterfall, investors receive the capital they invested in transactions that have been realized (i.e., sold) plus

6 Inside the Minds the preferred return, if any, before the general partner is entitled to its share of the fund s profits. The full priority return model typically results in the general partner waiting longer before it may participate in the fund s profits. Conversely, a realized invested deal-by-deal waterfall generally enables a general partner to participate in profits more quickly, but may result in the obligation of the general partner to return some of those profits to the limited partners if initial profits are offset by subsequent losses. In addition, the waterfall must work properly and on a tax-effective basis. Other related economic issues include the nature and magnitude of management fees, the profit-sharing percentage, the preferred return and its application, and the general partner s ability to charge the fund or its portfolio companies transaction fees. As fund counsel, it is very important to make sure the economics are appropriate to the organization and that they work in a way that will be palatable to the prospective investors. Thus, in preparing a fund s term sheet, it is necessary as an initial matter to assess the prospects and investor demand for the fund in order to determine how best to position the client in the marketplace to facilitate their effective and successful fundraising. Overly aggressive documents can scare away investors and make the fundraising process much more difficult. As a general partner, you want to be able to make as much money as possible, but to do so in a way that gives the limited partners comfort that if the general partner makes money, it means the limited partners are also making money and that they are making more money than they might investing elsewhere. A first-time fund manager will typically need to provide more favorable economics to its limited partners than a well-established fund manager with a strong track record. While overly aggressive terms can hamper the fundraising process, terms that are too friendly to investors may result in the client leaving money on the table. In addition, there are a series of risk allocation issues that are important, including how to deal with tax issues, how to address concerns that arise pursuant to the Employee Retirement Income Security Act, the prospect of lawsuits or indemnities, and what to do if the general partner receives too much of the fund s profits over the life of the fund. We try to work through each of these provisions so that we are best protecting our client, the fund manager, and presenting a document with a set of business terms that will be acceptable to the relevant investors.

7 Mastering a Dynamic and Innovative Capital Market Other important issues to address, and that can go wrong, involve the execution and continuing operation of the fund, including, for example, what occurs if the general partner violates the terms of the agreement or if something happens to the manager or its key personnel. It can be very difficult to unwind a private equity fund portfolio once it has been put in place, so it is important to address how to manage potential transition issues and the ongoing management of the fund. Still another preliminary issue to address involves the resolution of potential disputes that may arise between the general partner and the limited partners. A large part of any fund formation practice involves not only setting out the fundamental business terms and preparing for things to go well but also trying to anticipate things that might go wrong and how such situations should be addressed. Therefore, clients can make mistakes simply by not anticipating all of the issues that may arise during the life of a fund. Often, clients will want to keep their documents simple and transparent. These are both good things, but if too much detail is lost, a fund manager faces the prospect that it will not have all of the necessary tools to address a problem or issue that may arise years in the future. There are many standard protections that must be incorporated in a fund s documentation and many that are specific to a particular investment advisor or manager. Thorough fund documents will address each of the issues that are most likely to arise with respect to a given manager s investment program and anticipated investor base. Financial Implications From an investor s perspective, the money is the main issue. The documents are a framework for allocating profits and losses, and for allocating the risk associated with anything that might go wrong. The most expensive investment-related issue for the client is the worry of going out with terms that are too aggressive and, as a result, raising less money than the client might have otherwise been able to. Other situations that can be expensive for the client include lawsuits or other liabilities requiring indemnification once the fund has been organized. Fund partnership agreements generally include exculpation provisions, which protect against liability for actions that don t involve certain disqualifying conduct (e.g., gross negligence, fraud, and willful misconduct). If there is an

8 Inside the Minds occurrence that gives rise to a lawsuit and damages, this provision will govern who bears the costs of settlement and the other consequences deriving from the events that gave rise to the lawsuit. Private Equity Fund Components When first setting up a fund, I start with several critical issues, including who the sponsor is, where the sponsor is based and how it is organized, and an assessment of the issues relating to the sponsor s proposed investment program. For instance, if a fund is investing in the United States but has foreign investors, there may be a particular sensitivity to U.S. tax consequences arising from these investments. In particular, foreign investors, as a rule, do not want to pay taxes or file tax returns in the United States, and we therefore seek to provide clients with structures that are intended to shelter or protect investors from the prospect of having to do so. This is not always avoidable, but there are typically ways to block any return obligations, sometimes through the use of a foreign corporation. For American investors, there are numerous issues relating to the tax status of particular investors, including private and government pension plans, foundations and endowments, and taxable investors, and there are equally numerous structures employed to address such issues. The second issue I typically address is the question of who the anticipated investors are and the issues that arise by virtue of that anticipated investor base. If a fund anticipates raising a significant amount of money from pension plans, then the documents must provide protection under the Employee Retirement Income Security Act, the principal law governing private pension plans in the United States. The most common way of addressing these issues is to limit the amount of participation by pension plans and government plans to 25 percent of a fund s aggregate commitments or to qualify the fund as a venture capital operating company. If a fund qualifies as a venture capital operating company, it can have as much as 100 percent of its capital coming from pension plans and remain exempt from the Employee Retirement Income Security Act. A fund qualifies as a venture capital operating company by obtaining certain management rights with respect to its first investment, typically receiving

9 Mastering a Dynamic and Innovative Capital Market the right to appoint a board member, or to exercise rights that are substantially similar to the rights a board member would have. Globalization of Private Equity The private equity industry is becoming increasingly global in nature. U.S. managers are investing outside the United States, non-u.s. managers are investing in the United States, and fund sponsors are frequently raising money on a global basis. As a result, fund sponsors and their counsel need to work within the laws of the country or countries in which the fund sponsor operates and the laws of the jurisdictions in which the sponsor is raising money. Invariably, the fundraising process raises a host of securities and tax law issues. A sponsor must determine if it can offer interests in a fund to residents of a particular jurisdiction and, if so, what restrictions apply to the offering, including the nature or number of offerees and what procedures must be followed. As noted above, in the United States, private equity funds are raised on private placement basis. The U.S. Securities Act of 1933 establishes a safe harbor for the sale of unregistered securities. In order to fall within this safe harbor, a fund sponsor must be careful to ensure that the offering occurs on a private basis and that the sponsor does not inadvertently engage in a general solicitation or offering to the public. Also, prospective investors must satisfy the requisite net worth or income requirement associated with the private placement safe harbor. Foreign jurisdictions often employ similar private placement regimes, and a fund sponsor must be certain that it is complying with the securities laws in each of the jurisdictions in which it is offering interests in the fund. Another area of relevance to investors involves tax filing and payment obligations, including the treatment of an investment in the fund in each investor s local jurisdiction. The jurisdiction in which a fund is organized and the jurisdiction(s) in which it will invest will determine the tax consequences to an investor located in a given jurisdiction resulting from an investment in the fund, of which the consequences may be quite onerous

10 Inside the Minds without careful planning. Therefore, a fund sponsor must ensure that its documents satisfy not only the securities rules but also the tax rules, in any country where interests in the fund are being sold. Significant Laws The two principle laws related to private equity or investment funds are the Securities Act, which governs the private placement and sale of securities on an unregistered basis, and the U.S. Investment Company Act of 1940, which sets forth the conditions pursuant to which an investment fund must register (or may be exempt from registration) with the Securities Exchange Commission as a registered investment company. Registered funds are subject to a host of rules such as diversification limits, reporting obligations, and other restrictions. These rules can make it very difficult for a private equity fund manager to conduct a typical private equity fund investment program, and private equity fund sponsors therefore typically rely upon one or more exemptions from registration under the Company Act. The principle approach taken by effective counsel to fund sponsors to ensure compliance with these two acts is the preemptive approach. This means discussing the issues with a client before the client begins to raise funds, and ensuring that the client understands what hurdles must be cleared (and what must be avoided) in order to comply with the private exemptions both in the United States and in other jurisdictions they wish to enter. In addition to ensuring compliance with the Securities Act and Company Act, fund managers need to be aware of the U.S. Investment Advisors Act of 1940 and comparable laws in the jurisdictions where the fund manager operates. While many private equity managers are exempt from many of the most onerous aspects of the Advisors Act, if a U.S. fund manager has fifteen or more clients, it will become subject to the Advisors Act registration requirements and the compliance obligations associated with life as a registered investment advisor. Not surprisingly, the regulatory status of a fund sponsor or manager affects not only a fund s documents, but also the conduct and administration of that sponsor or manager, as well as the operation and governance of the funds they manage.

11 Mastering a Dynamic and Innovative Capital Market There are a number of ways we help our clients navigate these laws. The first is to determine the extent to which the client is familiar with these issues and discuss those issues with which they are not familiar in order to build an understanding of the requirements and consequences for the client s particular investment fund or overall business. We make sure that, to the extent a client cannot avail itself of any relevant exemptions, the client understands the consequences and obligations of operating in the more regulated environment of a registered advisor. For instance, the client must determine if it has the resources and understanding to comply with disclosure and reporting obligations in an appropriate fashion. Noncompliance Clients also must be aware of the consequences of noncompliance with applicable laws. For instance, if a client inadvertently exceeds the fourteen client limitation necessary to maintain its exemption as a private investment advisor, the client would be required to register with the Securities and Exchange Commission and would find itself subject to the regulatory oversight and disclosure obligations (and the related costs) arising in connection with such registration. As a general rule, most people are careful about this and make sure they are either aware of the limits to the number of clients they can have or that they are in a position to register as an investment advisor. We therefore make a point to assess the likelihood of any past noncompliance and prevent the possibility of future noncompliance as part of the initial diligence process when setting up a new fund. Recent Regulatory Developments Affecting Private Equity Funds Although industry regulation has been relatively stable for the past year, over the past five years there has been an unprecedented wave of regulatory change. These new regulations have in turn caused significant change in the industry. Recent changes include amendments to the rules issued under the Advisors Act, which includes an alteration to the manner in which clients are counted for purposes of determining the Advisors Act registration exemption, and

12 Inside the Minds enhanced compliance requirements applicable to registered advisors, including new custody and reporting obligations. While these Advisors Act developments have been directed primarily at hedge fund managers, some of the new rules are already affecting private equity fund managers. Other changes that have affected the industry include the Sarbanes-Oxley Act of 2002, which can affect private investment funds that are sponsored or managed by publicly traded companies, publicly traded portfolio companies, and the consequences associated with taking portfolio companies public. Some of the anti-money laundering regulation and antiterrorism (e.g., Patriot Act) developments have also affected the structure and documentation of private equity funds. More attention is now paid to the identity of investors, and certain anti-money laundering and antiterrorist protections must be incorporated into a fund s documentation. There is an obligation as a practical matter to know who a fund s investors are (and that such investors are not terrorist suspects) and to achieve a degree of comfort that a limited partner s money is not derived from illegal activities. Another area that has been the subject of focus by the private equity industry is the application of Freedom of Information Laws. Many fund sponsors are concerned that information about their investment programs and individual portfolio companies might become a matter of public record as a result of investors submitting information requests to the government. This has meant that some fund managers are now routinely excluding government plans from participating in their funds. For managers who do take government plan money, there is a great deal more attention paid to the confidentiality provisions in fund documents and the nature of their reporting regarding the fund, its activities, and its portfolio. Going back slightly farther, the Investment Company Act was amended in 1996 to facilitate the formation of larger, unregulated funds pursuant to the National Securities Markers Improvement Act, which permitted the formation of what are known as 3(c)(7) funds. Historically, a private equity investment fund could only be organized under the 3(c)(1) exemption, which limits participation to 100 accredited investors or to an entity with assets of at least $5 million. This 1996 amendment permitted 3(c)(7) funds

13 Mastering a Dynamic and Innovative Capital Market to accept an unlimited number of investors so long as each such investor was either a natural person with an investment portfolio of at least $5 million or an entity with an investment portfolio of at least $25 million. This was one of the most significant changes in the industry over the past ten years, and it has fueled enormous growth in the industry. A further change involves placement agents, who receive a fee for fundraising activities. Placement agents are subject to the rules issued by the National Association of Securities Dealers, the self-regulatory agency that supervises the activities of U.S. broker-dealers. Approximately three years ago, the National Association of Securities Dealers limited the use of related performance information in the context of raising money for private investment funds. There are restrictions on the use of related performance for fundraising activities, and as a rule, if a sponsor is raising money for a fund, the sponsor may disclose only the performance of that fund. This development created an enormous outcry in the private equity fund industry, where each new fund is a brand new entity and therefore has no performance history of its own. These rules have affected the nature of disclosure and the types of disclosures that can be included in marketing materials, and the National Association of Securities Dealers has been aggressively trying to prevent the use of misleading marketing information. It is therefore extremely important that clients understand these rules and how they impact the fundraising process. Prospective Regulatory Developments I think there is some possibility that in time, the Advisors Act rules will be expanded to require Securities and Exchange Commission registration by private equity fund managers. As a lawyer, regulatory changes are typically good for business. From a client perspective, however, such developments typically mean increasing internal compliance infrastructure supervision. These include hiring new people and developing policies and procedures to ensure compliance with the Advisors Act and other applicable laws. Securities and Exchange Commission supervision can be an expensive proposition involving extensive business, operations, and compliance disclosure. Many of the larger fund managers are already dealing with these requirements. To the extent last year s Advisors Act changes are extended

14 Inside the Minds to apply directly to managers of private equity funds, compliance costs can be expected to rise significantly and the barriers to entry to the industry, particularly for managers of smaller funds, will also increase. It is worth noting that while many investors may welcome the increased discipline and transparency that would accompany registration under the Advisors Act, institutional investors in private equity funds typically already negotiate similar protections into fund documents as a matter of course, resulting in a degree of self-regulation. There also is a reasonable prospect that anti-money laundering obligations will be strengthened in the future. As a general rule, many private equity funds are currently exempt from those obligations. If these rules are extended to private equity funds, managers will need to increase their antimoney laundering diligence. Although many managers have already instituted more rigorous anti-money laundering programs than are technically required, heightened regulation will invariably further raise the costs of doing business. Another significant change involves foreign jurisdictions that are seeking to facilitate the further growth of the private equity funds industry. Industry groups in Europe are currently working to introduce a European Unionwide private placement regime. If these efforts are successful, such a unitary European private placement regime would clearly facilitate fundraising among European investors. Similar initiatives are occurring in other jurisdictions such as Singapore, which are trying to update their private fund and private placement rules in order to facilitate further growth. Happily, there is always ongoing competition among particular jurisdictions to make their rules more effective from a fund formation perspective. The private equity funds industry is an extraordinarily dynamic and innovative capital market and has experienced tremendous growth over the past ten to fifteen years. There is every indication that this growth will continue and that the industry will become more global in nature and more competitive as time goes by. Recent innovations, including the Euronext listing of perpetual life private equity funds of funds, are a testament to the continuing strength of investment in private equity and its ability to generate economic growth and profits for fund managers and investors.

15 Mastering a Dynamic and Innovative Capital Market Stephen Culhane is a partner in King & Spalding s private equity and investment funds practice group. Mr. Culhane advises clients in a wide range of private investment fund formation and investment, investment management, and corporate matters. He has extensive experience representing the sponsors, managers, and distributors of private investment funds including private equity funds, private equity funds of funds, hedge funds, hedge fund funds of funds, and real estate private equity funds. Over the course of his career, he has assisted private fund sponsors with the formation, marketing, and launch of more than 150 private investment pools, which collectively have raised in excess of $20 billion from institutional and high net worth investors around the world. In addition, Mr. Culhane has advised institutional investors in private funds, negotiating primary and secondary investments in more than 300 distinct private investment funds. He has also represented investors in numerous venture capital and leveraged buyout transactions. Mr. Culhane joined the firm from Goldman, Sachs & Co., where he served as vice president and associate general counsel, as the legal director to the Goldman Sachs private equity group, a leading private equity fund of funds complex, and as the senior attorney for many of the alternative investment funds managed by Goldman Sachs asset management. These funds included U.S.-, Cayman Islands-, and Irish-domiciled equity long-short hedge funds, currency trading funds, multi-strategy hedge funds, exchange funds, collateralized bond obligation vehicles, and funds of hedge funds. Mr. Culhane graduated, cum laude, from Princeton University, received a master s degree in politics from the University of Oxford, and earned his J.D. from the New York University School of Law. He is a member of the Association of the Bar of the City of New York, where he serves on the committee on private investment funds, and he has been recognized in Chambers USA: America s Leading Lawyers for Business in the area of fund formation, as well as in The International Who s Who of Private Funds Lawyers, The Expert Guide to the World s Leading Private Equity Lawyers, and the New York section of the 2007 edition of The Best Lawyers in America Guide. Mr. Culhane is a frequent speaker on issues relating to private investment funds.

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17 Aspatore Books is the largest and most exclusive publisher of C-Level executives (CEO, CFO, CTO, CMO, Partner) from the world's most respected companies and law firms. Aspatore annually publishes a select group of C-Level executives from the Global 1,000, top 250 law firms (Partners & Chairs), and other leading companies of all sizes. C-Level Business Intelligence, as conceptualized and developed by Aspatore Books, provides professionals of all levels with proven business intelligence from industry insiders direct and unfiltered insight from those who know it best as opposed to third-party accounts offered by unknown authors and analysts. Aspatore Books is committed to publishing an innovative line of business and legal books, those which lay forth principles and offer insights that when employed, can have a direct financial impact on the reader's business objectives, whatever they may be. In essence, Aspatore publishes critical tools need-to-read as opposed to nice-to-read books for all business professionals. Inside the Minds The critically acclaimed Inside the Minds series provides readers of all levels with proven business intelligence from C-Level executives (CEO, CFO, CTO, CMO, Partner) from the world's most respected companies. Each chapter is comparable to a white paper or essay and is a futureoriented look at where an industry/profession/topic is heading and the most important issues for future success. Each author has been carefully chosen through an exhaustive selection process by the Inside the Minds editorial board to write a chapter for this book. Inside the Minds was conceived in order to give readers actual insights into the leading minds of business executives worldwide. Because so few books or other publications are actually written by executives in industry, Inside the Minds presents an unprecedented look at various industries and professions never before available.

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